Investing.com – Professor Dr. Jan Viebig, Global Co-CIO ODDO BHF AM, explains in this article the keys to stagflation, why it is happening and what consequences it will have on financial markets in the months to come.
- As the risk of recession increases, we favor defensive stocks.
- The economy will slow, which could lead to negative adjustments to earnings estimates in the coming quarters.
- Short-term interest rates will continue to rise and yield curves will likely continue to flatten.
“Prepare for an economic hurricane,” warns Jamie Dimon, CEO of JP Morgan (NYSE:). Whether it is a real storm or a hurricane is of course not a foregone conclusion.
The global economy is currently experiencing a supply shock that could lead to an economic crisis. For ODDO BHF AM, a supply shock has 6 economic effects which can be described as follows:
- The increase in commodity prices following the conflict in Ukraine causes an increase in inflation.
- The increase in inflation acts as a “tax on the”. In other words, those who spend more at the pump have less money available to buy other goods and services.
- High inflation, sooner or later, leads to higher interest rates, as we are already seeing in the United States and soon in Europe.
- Higher interest rates lead to lower investment and slower growth.
- Following a supply shock, uncertainty increases in the economy, following rising input costs, supply chain problems or increased credit defaults, for example.
- An additional possible consequence is a wage price spiral, if unions can impose an upward compensation for inflation in the form of higher wages.
Markets should prepare for slower growth with high inflation. On both sides of the Atlantic, an 8 precedes the comma: in the United States, annual inflation stood at 8.3% at the end of April and in the euro zone, Eurostat estimates the annualized inflation of prices consumption at 8.1% at the end of April. May 2022. The likelihood that the United States will experience a recession in the next 12 months has recently increased. However, it remains at just over 30. In Europe, the economy is cooling more markedly than in the United States. A recession would be inevitable in Europe if an embargo were imposed on Russian gas or if Russia cut off supplies.
The current economic situation, with all the differences that historical comparisons always imply, recalls the situation in 1973-1974, when Arthur Burns headed the Federal Reserve. Burns is now considered overly cautious, in part because he bowed to pressure from the US government.
President Richard Nixon, facing new elections, advocated low interest rates. Thus, the Fed raised interest rates too late and too slowly after the first oil shock, having failed to prevent rising inflation expectations from driving up wages.
The central bank’s strategy
The current situation seems similar, as the war in Ukraine is causing an energy price crisis. Oil has risen from around $70 a year ago to $120 now as ambitious stimulus from Presidents Trump and Biden has fueled inflation. Under the “Taylor Rule”, the Fed continues to act today too late and with too much hesitation, because actual inflation is well above the inflation target and the US economy is firing on all cylinders. High inflation will almost certainly force the two major central banks, the IAC and the ECB, to raise interest rates above the neutral rate.
Additionally, the Federal Reserve announced that it would reduce its balance sheet through a quantitative adjustment, thereby removing market liquidity. Investors would do well to prepare for the end of the era of cheap base money. Inflation is likely to come down more slowly than central banks on both sides of the Atlantic expected at the start of the year, given high energy prices. In our view, a short bond duration is always advisable. Short-term interest rates will rise significantly and yield curves will flatten.
Flat or inverted yield curves generally indicate an increased probability of recession. As the likelihood of a recession increases, we remain cautious on high yield bonds. In the past, it has been prudent to invest in high yield only when recession has set in and yields have risen sharply. We are not there yet. Defensive value stocks will likely continue to outperform expensive growth stocks in a rising interest rate environment.
In the coming quarters, supply chain issues and rising costs could put further pressure on margins. Therefore, we focus on investing in companies with strong pricing power. We remain fundamentally cautious and keep equity quotes below the neutral quotes agreed with our clients. China offers a first ray of hope.
The latest news from the Middle Kingdom indicates that policymakers will take stimulus measures and relax the strict “zero Covid” policy. As I said before, it remains uncertain whether we can expect a light storm or a severe hurricane.
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